Tax Treaty

A tax treaty is an agreement under international law concluded between two countries. In the event of a threat of double taxation, this agreement governs how and to which extent existing taxation rights are exercised and restricted. This is based on the fact that every country can, based on its sovereignty, tax the income generated by taxpayers based (residing) in its territory worldwide or the assets of such taxpayers (sovereignty principleand world income principle). Since well before the current increasing globalisation, many natural or legal entities have increasingly operated internationally Classic examples of this include employees working in a neighbouring country, business premises abroad of a domestic company or a real estate property abroad generating income from leasing and letting. These international matters give rise to the tax law question of which country can tax the income and which country dispenses with taxation to ensure that the taxpayer is not subject to a double tax burden. The respective tax treaty between the two countries concerned governs the prevention of double taxation of the same transaction. Compared with the unilateral waiver provisions of every country, the “advantage” of these bilateral measures is that it is more effective at preventing double tax burdens.

Initially, the question of who (subject of taxation) and what (object of taxation) is taxed by the respective country is established on the basis of the national tax laws. Based on the principle of sovereignty, every country can determine the scope of taxation and the relevant points of reference for itself. In this context, we differentiate between unrestricted and restricted tax liability. As a rule, the unrestricted tax liability is based on the natural person or legal entity, i.e. nationality or residence. In the framework of the unrestricted tax liability, all national and international income is taxed (global income or universality principle). The restricted tax liability is generally connected to the taxable object and its location or source. Here, only the assets located in the country or the income from domestic sources are taxed (principle of territoriality).

For example, section 1 sub-section 1 German Income Tax Act provides for the unrestricted income tax liability of natural persons who reside in the country or have their habitual residence there. However, according to section 1 sub-section 4 EStG, there is a restricted income tax liability for those persons who do not reside in the country or have their habitual residence here but still generate income in the country according to section 49 EStG. These are usually sources of income from the country. Similar provisions are also found in other individual tax laws, such as in section 1 of the German corporate tax law. Then, the German fiscal code [AO] as the upstream procedure law defines the relevant connection points according to sections 8 ff AO, i.e. place of residence (section 8 AO), habitual residence (section 9 AO), management (section 10AO), registered seat (section 11 AO) or business premises (section 12 AO) independently of the respective tax type.

Since there are provisions just like these in many countries, a situation can arise in which, according to the respective national tax laws, the taxpayer is subject to an unrestricted and restricted tax liability in both countries at the same time or in which the taxpayer is subject to an unrestricted tax liability in both countries or subject to a restricted tax liability in both countries. This is illustrated with the following examples:

Unrestricted tax liability in the country of residence and restricted tax liability in the source country

For example, taxpayer A resides in Aachen (Germany) but works for a company based in Maastricht (Netherlands). As a result, he has unrestricted tax liability in his country of residence, Germany. In the Netherlands, he is subject to a restricted tax liability because of the income generated there from gainful employment.

Taxpayer B resides in Italy but owns a real estate property in Munich from which she generates income from leasing and letting. Because of her residence, she has unrestricted tax liability in Italy. As the source country, however, Germany also wants to tax the income from the source located in the territory of Germany (real estate property).

Unrestricted tax liability in both countries

Taxpayer C is an American citizen but has lived in Cologne for several years. The relevant criterion under German tax law is residence. In the USA, however, the relevant criterion is nationality, which is why C is subject to unrestricted tax liability both in Germany and in the USA.

Restricted tax liability in both countries

Taxpayer D is based in Hamburg and owns a company. She sets up business premises in another country. These business premises, in turn, hold shares in a limited liability company based in a third country. Double taxation for Germany results in those cases in which, as a the source country, the third country wants to tax dividends, while, at the same time, the country in which the business premises are located allocates the income from the shareholding in the limited liability company to the income of the business premises.

This means if a natural person or legal entity is based in several countries according to the respectively valid national provisions, the tax treaty govern which country is to be considered the country of residence based on the convention law. Just like in tennis, a tie break is decisive here - in the convention law, this comprises a test sequence which finally resolves which country the person is considered to be residing in under convention law. 

Many of the tax treaties which Germany has concluded with other countries correspond to the OECD sample agreement (OECD SA) in many respects. There are detailed provisions for income taxation, for example on income from immovable assets (art. 6 OECD SA), company profits (section 7 OECD SA), dividends (art. 10 OECD SA), income from (self-) employed work (art. 14, 15 OECD) as well as provisions regarding asset taxation (art. 22 OECD SA).

The question of how double taxation is ultimately prevented is covered in the article regarding the method employed to avoid taxation (art. 32 OECD SA) which differentiates between two fundamental approaches - the exemption methodand the consideration method.

• If the foreign income is subject to taxation in the source country, this income is exempt from taxation in the country of residence (subject to the progression proviso) (exemption method - art. 23 A OECD SA). For example, this applies to the income from immovable assets or profits of business premises.
• If, in contrast, the source country waives taxation in part, the tax paid in the source country is considered with regard to the tax paid in the country of residence (consideration method - art. 23 OECD SA). This, e.g., applies to dividends.

With regard to interest and license fee payments, the fact has to be considered that these are to be taxed in the country of the payment recipient rather than in the source country. However, in the case of affiliated companies from various EU member states, these payments are exempt from taxation, as a rule.

The far-reaching uniformity in taxation between countries that have concluded a tax treaty based on the OECD SA facilitates the procedure in this case. This applies, in particular, if taxation is effected across national borders. However, there are also countries that have concluded tax treaties deviating from this. This applies, in particular, in the case of the tax treaty between Germany and the USA which only uses the consideration method to avoid double taxation and, as a result, deviates from the provision in the sample agreement.

Nonetheless, the respective individual case always has to be analysed. This applies to all tax treaty including those based on the OECD SA model since there are almost always minor deviations. Moreover, the inclusion of the corresponding additional protocols is also required.

Based on skilful tax designs, it was possible to use the provisions under tax treaty in such a way in the past that the relevant income was not taxed in any of the countries involved (so-called white income). This was usually due to agreement conflicts, i.e. qualification conflicts in which the same matter was given a different legal qualification by the countries involved. Examples of this include different qualifications as equity or third-party capital or as a corporation or an unlimited company. The national states have now recognised the risks involved for their tax income and have tried to counteract this using so-called “subject-to-tax clauses” in the STA convention law (e.g. Art, 24 German-Italian tax treaty) and in national provisions (e.g. Section 50d EStG) for some years. 

Since we do not have tax treaty for all countries, there is the question of how to avoid the threat of double taxation in these cases. In these cases, the national tax laws alone govern whether and how double taxation is avoided. This is usually done through the consideration or the deduction of taxes paid abroad. In other words, if there is no tax treaty between the countries involved, the consideration method is usually used to avoid double taxation (section 34c sub-section 1 sentence, sub-section 6 sentence 1 EStG). However, the fact has to be considered that the foreign tax can only be considered up to a maximum amount. This maximum amount is calculated using the equation in section 34c sub-section 1 sentence 2 EStG. If the foreign tax exceeds this maximum amount, the surplus (so-called consideration surplus) cannot be considered. Moreover, this surplus cannot be considered elsewhere. As a result, it leads to effective additional and/or double taxation for the taxpayer.

If the foreign tax cannot be considered according to section 34c sub-section 1 EStG for the simple reason that the preconditions are not fulfilled, the deduction of the foreign tax according to section 34c sub-section 2, sub-section 3 EStG has to be checked. This shows that these have a backup function. According to section 34c sub-section 3, the deduction of foreign taxes in the determination of income is provided for in the following cases:

1. The foreign tax does not correspond to the German tax;
2. The foreign tax is not charged by the country in which the income was generated;
3. There is no foreign income within the meaning of Section 34d EStG. Typically, these are cases in which the foreign government charges tax on income which constitutes domestic income according to national tax law (with the most frequent application being assembly sites).

Finally, the foreign tax must have been assessed and paid and there must not be any reduction claim regarding such tax. In this case, the foreign tax is deducted from the income which is subject to the German income tax. In contrast to section 34c sub-section 1 EStG, there is no maximum calculation in deductions under section 34c sub-section 3 EStG (and also in cases under section 34c sub-section 2 EStG).